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Indian Banking System Faces Unprecedented Liquidity Deficit

The banking system approached a liquidity deficit of approximately Rs 1.47 trillion on Monday, marking the highest level since January 29, 2020, when the liquidity deficit in the banking system had reached Rs 3 trillion. 

To address this, the Reserve Bank of India (RBI) injected Rs 1.47 trillion on Monday and an additional Rs 1.46 trillion on Tuesday. Despite this substantial injection, market participants expressed concerns that the disbursement of Rs 25,000 crore as the second tranche of incremental cash reserve ratio (I-CRR) might not be sufficient. They feared that liquidity could further tighten in the short term, possibly reaching Rs 2 trillion, due to tax outflows and the onset of the festival season. 

Before delving deeper into this matter, it’s important to gain a comprehensive understanding of the current situation. 

Understanding Liquidity Deficit 

A liquidity deficit in the banking system is a situation where a bank or a banking system as a whole does not have enough liquid assets (such as cash and reserves) to meet its short-term obligations, including customer withdrawals and payment obligations. This can create financial stress and operational challenges for banks, potentially leading to disruptions in the overall financial system. 

Central banks often play a critical role in providing liquidity to banks facing a deficit to maintain stability in the financial system. They do this through various tools, such as open market operations and lending facilities, to ensure that banks can meet their short-term obligations and avoid disruptions. 

Understanding I-CRR 

Before delving into the concept of incremental cash reserve ratio (ICRR), it’s essential to grasp the fundamentals of the cash reserve ratio (CRR). Under CRR, banks are mandated to maintain a certain portion of their deposits and specific other liabilities in the form of liquid cash with the Reserve Bank of India (RBI). This mechanism serves as a tool for the RBI to manage liquidity within the economy and can also act as a safeguard during periods of banking stress. 

In instances of surplus liquidity within the system, the RBI has the option to implement an incremental credit reserve ratio, which is an additional requirement on top of the CRR. Essentially, this means that banks will be obliged to hold a higher amount of liquid cash with the RBI. 

As per the RBI’s monetary policy statement, effective from August 12, 2023, all scheduled banks were mandated to maintain an extra cash reserve ratio equivalent to 10 per cent of the increase in their net demand and time liabilities (NDTL) between May 19, 2023, and July 28, 2023. This measure comes against the backdrop of the RBI’s earlier announcement regarding the withdrawal of Rs 2,000 notes during this period, leading to significant deposit inflows. The RBI’s objective was to withdraw some of this excess money from the financial system. 

Impact of measures by RBI 

The primary objective of the RBI with the implementation of this measure was to curb inflation. Basically, by withdrawing liquidity from the system, banks will have less capital available for lending, leading to reduced demand for goods and services, thereby exerting downward pressure on prices. Additionally, short-term interest rates may rise due to the tightening supply of funds in the economy, serving as another tool to combat inflation. 

The introduction of an incremental cash reserve ratio (I-CRR), albeit on a temporary basis, would tie up banks’ resources and contribute to upward movements in market interest rates. While some surplus liquidity may still exist in the market, the concept of locking up resources will create a sentiment that puts upward pressure on interest rates. 

However, it’s worth noting that there hasn’t been a substantial influx of dollars into the system, and the RBI has been actively preventing such inflows. There hasn’t been any significant foreign exchange inflow, and the RBI isn’t inclined to inject durable liquidity into the system. Consequently, the RBI decided on September 8, 2023, to phase out the I-CRR by October 7, 2023. 

As part of this phased approach, 25% of the total I-CRR will be released on September 19, 2023, another 25% on September 23, 2023, and the remaining 50 per cent on October 7, 2023. We are currently approaching the end of September, and the pressure on liquidity is being exacerbated by advance tax payments. Furthermore, the depreciation of the rupee beyond Rs 83, coupled with RBI interventions, has absorbed additional rupee liquidity from the system. 

Disclaimer: This blog has been written exclusively for educational purposes. The securities mentioned are only examples and not recommendations. It is based on several secondary sources on the internet and is subject to changes. Please consult an expert before making related decisions.

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